You may or may not know this but Warren Buffett once made a small fortune investing in crappy companies. He then used part of that small fortune to buy a controlling interest in a crappy company and turned it into a conglomerate.
That story gets retold in some form every time Buffett or Charlie Munger sit in front of an audience. Which is exactly what Munger did in an interview a few months ago:
CM: Well Warren had been taught by Ben Graham to buy things for less than they were worth, no matter how lousy the business was. You can’t imagine a more lousy business than New England textile mills because textile is a congealed electricity. And the electricity rates in New England were about 60% higher than TBA rates. So it was absolute, inevitable, certain liquidation.
Now Warren should have known better than to buy into a totally doomed enterprise, but it was so damn cheap. We could buy it at a big discount from liquidating value. So he bought a big chunk and finally he ended up in control of the business. But the business was gonna die. So the only way to go forward from there was to ring enough money out of this declining textile business to have more money that he’d paid to get in and use it to buy something else.
Well that’s a very indirect way to proceed, and I would not recommend it to any of you. Just because we did some dumb thing that worked, you don’t have to repeat our path. And of course, we eventually learned not to buy these cigar butts when they were cheap, and do these painful liquidations. And start buying better businesses.
That’s the main secret of Berkshire. The reason that Berkshire has been successful as a big conglomerate – more successful than any other big conglomerate, so far as I know any other big conglomerate in the world – the reason it’s been successful is we try and buy things that aren’t going to require much managerial talent at headquarters. Everybody else thinks they’ve got a lot of managerial talent at headquarters. And that’s a lot of hubris. If the business is lousy enough and it gets a wonderful manager – the business has a lousy reputation, then the manager has a good reputation – it’s the reputation of the business that’s going to remain intact. You can’t fix these really lousy businesses. You can ring the money out, whatever comes in liquidation and do something else with it. But most lousy businesses can’t be fixed.
SD: But at the time, Warren was – that’s what he was doing. And so…
SD: How did you convince him.
CM: I helped him. He bought a windmill company in a little town in Nebraska. And Warren didn’t know anything about running a windmill company, he bought it because it was cheap. And he said, what are you doing, why can’t you fix my windmill company, who could you get to help me. I said, I’ve got just the man for you. And so one of my old colleagues from a transformer business, that was an accountant, I said he will fix your windmill company. And Warren was desperate, He just hired him on the spot.
And Harry walked in that first day, this little town, this big collection of windmills and so forth. And the whistle blew, and the whole plant stopped for 15 minutes. And he said what the hell is this? And I said well it’s respect for the town. Anybody has a funeral, we blow this whistle and stop for 15 minutes. And Harry said, that’ll be the last time.
And he just approached everything that way. And of course, another thing he did is he cut away all the fat that he didn’t need, and then he found there were certain parts where we were the sole supply and he raised all the price of those parts. You can see what a business genius we are.
SD: So how did you convince Warren to stop buying the bad apples and start buying the good apples?
CM: I think Warren, he gives me credit for that. He was going to learn it anyway. He just made so much money in this other stuff and he’d been taught it by Ben Graham. It was hard for him to quit when he was just coining money. But he saw the point. You couldn’t scale that business. And it was kind of scroungy, and unpleasant, and you’re firing people, who in the hell wants to do that? So we just wrung the money out and bought better businesses. And we’ve been doing it ever since.
More details of those early days can be found in the Buffett Partnership Letters.
It’s safe to say Buffett was forced to change. If he wanted to build Berkshire into a conglomerate that might stand the test of time, he had to stop buying businesses like Berkshire Hathaway, the textile company.
Normal investors don’t have that problem.
Buying quality companies is a nice idea to have. But it takes a fine-tuned qualitative view to not only distinguish great companies from great investments but to find quality companies that will last in extremely disruptive competitive markets…at a good price. Buffett makes it sound much easier than it really is to put a value on those qualitative factors.
And it turns out not all lousy businesses end in immediate liquidation. There are cyclical businesses, turnaround stories, commodity businesses, businesses that sell commodity-like products, some businesses waver along for years before liquidation happens, and some get bought out. None of them will ever have high profit margins or great returns on capital or competitive advantages that qualify them as quality. But the market’s attitude toward all of these businesses rarely remains constant.
Howard Marks relates a useful lesson all the time:
I was very fortunate to learn a painful lesson early. You invest in the best companies in America and you loose almost all your money. Now, 10 years later I joined — I was asked to start a portfolio of high yield bonds. They used to call them junk bonds. Now, I’m dealing with the worst companies in America. So, what I learned from the combination of these two things is that investing is not a matter of what you buy, it’s what you pay. Investing is not a matter of buying good things, but buying things well. And you have to understand the difference between buying good things and buying things well. And I think that’s what we’ve been able to do.
So don’t overlook lower quality.
Ben Graham sought it out with his cigar butts in the 1940s and 50s (Buffett learned it from him) and later added other simple quantitative methods to do it.
Walter Schloss made a killing off of lower quality for over 50 years.
Peter Lynch, the most versatile investor ever, turned his eye toward cyclical and turnaround stories often. He even told a story in 2003 about buying a basket of cigar butts, all trading below their cash value – the remnants from the Dotcom crash.
Even the S&P 500 is full of average companies – one’s Buffett would never buy – that are just having a good run of late (and will eventually get replaced by something else).
Lowering your standards can lead to a fresh supply of beat up, unloved, unpopular, often despised and detested companies – nonetheless, real businesses with real profits – that the market consistently overlooks. They’re just the furthest thing from quality.
Be aware, it takes an iron stomach to do what Buffett (along with Graham, Schloss, Lynch, Marks…) did in his early years. So it’s not for everyone either.
- (More Than) a 2018 Investment Outlook – Above the Market
- 10 Things Investors Can Expect in 2018 – A Wealth of Common Sense
- The Realities of Mean Reversion – Validea
- The Rate of Return on Everything – ProMarket
- How Evolution Can Make Sense of the Stock Market – Atlantic
- Complexity Bias: Why We Prefer Complicated to Simple – Farnam Street
- The Thrill of Uncertainty – M. Housel
- Lessons from the 1980s for Disruption – 13D
- RIP IPO (1602-2018) – Tech Crunch
- The Business of Improving Global Health – B. Gates
- Artificial Intelligence will be a Symbiosis, Not a Replacement – Rational Optimist
- The 100-Year Capitalist Experiment that Keeps Appalachia Poor, Sick, and Stuck on Coal – Quartz
- The Extraordinary Life of Nikola Tesla – Smithsonian